Thursday, October 29, 2015

GDP from 30,000 feet

Quarterly GDP readings are notoriously volatile, and they are subject to substantial revision after the fact, so it doesn't pay to read too much into any one quarter's number. Third quarter GDP, released today, was in line with expectations, but it was disappointingly slow: a mere 1.5% annualized rate. Did the economy really take a nose dive, considering it grew at a 3.9% rate in the second quarter? Most likely not.

Given the vagaries of the quarterly numbers (see the first chart above), I've found it makes more sense to look at the rolling 2-yr annualized rate of growth of GDP, as shown in the second chart. Think of it as looking down on the economy from 30,000 feet, getting the big picture rather than the street-level map. It's clear this is a weak recovery, but notice how the pace of growth has actually picked up somewhat over the past year or so.

I'm not alone in making this observation: the bond market has figured it out too. The real yield on 5-yr TIPS has been trending higher over the past two years, tracking the rising trend in growth. The market senses that the economy is on somewhat firmer footing—even though growth is still sub-par—and thus the market is coming to accept the fact that the Fed is getting ready to raise short-term real interest rates.

In another sign that the economy is on firmer footing, weekly unemployment claims have fallen to their lowest level since 1973, and to the lowest level relative to total jobs on record (which goes back to 1967).

As the chart above suggests, the REAL big picture is one of an economy that has been growing at a sub-par pace (2.15% annualized) since the recovery began in mid-2009). If the economy had bounced back as it always did in the past, real GDP would be about 15% bigger: that translates into $2.6 trillion in "lost" income this year alone. That's arguably the measure of the cost of increased regulatory burdens, marginal tax rates that are too high, and years of Keynesian-inspired "stimulus" spending. This chart should make it painfully obvious that our highest priority should be to bend fiscal, tax, and regulatory policy in a more growth-friendly direction.


Benjamin Cole said...

Excellent blogging.

Still, would like to see monetary policy become growth-oriented too. I would say there is plenty to gain and little to lose in aggressive growth policies from the Fed.

marcusbalbus said...

so what does the "chart" look like 3 years rolling? why not 4? what is so magical about 2?

Scott Grannis said...

Benjamin: once again I'll ask you to explain how it is that the Fed can create growth with easy money.

Benjamin Cole said...

Scott Grannis: Well, we have a disagreement on the impact of QE. I believe QE cash enters the economy when bondholders sell their bonds to primary dealers, and primary dealers sell the bonds to the Fed. You do not. So we have to agree to disagree on this particular point.

So my answer is, the Fed could engage in QA (as does the Bank of Japan) or the Fed could reduce interest on excess reserves (which they never paid before).

I suppose the Fed could even go to negative interest on excess reserves, as has been tried in Europe.

My preferred approach is more QE. If QE is in fact inert, then fine, we will pay off the national debt, and that has got to be a little bit stimulative anyway!

My best idea is not legal under current law. That would be a FICA tax holiday, during which the Fed bought Treasuries and placed them into the Social Security and Medicare Trust Funds to compensate for lost revenues.

Scott Grannis said...

Benjamin: QE cash does not enter the economy when the Fed buys bonds from primary dealers. That is a crucial point you are overlooking. The Fed pays for the bonds it buys with bank reserves, and bank reserves are not "money" that can be spent. The proof is in the money supply statistics, which have risen about 6-7% per year despite trillions of QE bond purchases.

The banks have trillions of excess reserves that would support tens of trillions of new money, but it hasn't happened. Lowering the interest paid on those reserves might encourage the banks to make more loans, but that would be the equivalent of dropping money from helicopters, and all that does is push up prices. Money printing on a large scale does not translate into growth, only inflation. Argentina has plenty of experience with this.

We cannot pay off the national debt by having the Fed buy more Treasuries, except to the extent the Fed forced banks to increase their lending, in which case a huge increase in inflation would effectively pay down the debt.

A FICA tax holiday might encourage people to work more, but it would do nothing to encourage individuals and businesses to invest more.

This is not a matter of opinion, it is a matter of fact.

Benjamin Cole said...

Scott: Well, we disagree. I contend that when a bondholder sells a Treasury bond to a primary dealer, the bondholder ends up with cash. The primary dealer then sells the bond to the Fed and ends up with cash in the primary dealer's commercial bank account. A $1 sale results in $2 in cash creation.

So when the Fed buys a $1 T bond, $1 is added to a primary dealer's bank account, and $1 ends up in the bondholder's hands.

The bondholder then can buy stocks, bonds, property, or spend the $1. The bondholder can deposit the $1 in the bondholders bank account. Or the bondholder can convert the $1 into paper cash.

This is discussed in the New York Fed's website.

So, we disagree. But so what, the World Series is on.

BTW--PCE now at 0.2% YOY and 1.3% core. That is the Fed's preferred index of inflation. Their official target in 2.0%, which is supposed to be an average, not a ceiling.

Benjamin Cole said...

Scott Grannis: let me ask this: if the Fed today commenced another program to buy another one trillion of US Treasury bonds at the rate of $80 billion a month, what would be the results?
If inflationary, how so?

Scott Grannis said...

When a bondholder sells a bond to a primary dealer he does end up with cash, as you say. But the cash had to come from the dealer's stock of cash, which we know came from strong deposit inflows; in other words, the banking system took in trillions of deposits, and then used the cash to buy bonds which were subsequently sold to the Fed. When the dealer sells a bond to the Fed, the dealer ends up with bank reserves (which are NOT cash) in the bank's account with the Fed. The dealer may choose to use his reserves to create cash (e.g., by making a new loan which is funded with a cash deposit to the borrower's account). But we know from the history to date that primary dealers have not done that, since excess reserves (reserves not used to make new loans) are very close to the banks' net sales of bonds to the Fed.

Again, this is not a matter of opinion, it's a matter of fact. If you disagree then it means you fail to understand how our banking system works.

Scott Grannis said...

If the Fed were to do another $1 trillion of QE without increasing the interest it pays on excess reserves, I suspect that result would be more inflation, and not more growth, because I think the banks are happy with the amount of excess reserves they hold today. Very low swap spreads tell me that the banking system is flush with liquidity, and systemic risk is low. Low inflation tells me that the world has just about the amount of money it wishes to hold. Money supply and demand are in balance.

Increasing the amount of excess reserves without raising IOER could destabilize the system, giving the banks a strong incentive to reduce their excess reserves and increase their lending. This could result in an excess of money supply, and that in turn would lead to a weaker dollar and higher inflation.

However, if the Fed were to increase IOER then it is possible they could also engage in more QE without any inflationary consequences, but I am less sure about how that scenario would play out.

They key thing to focus on is the banks' willingness to hold the existing stock of excess reserves, which is about $2.6 trillion. Raising IOER, all else being equal, raises banks' demand for excess reserves. Increasing excess reserves without increasing IOER out to result in an effective reduction in banks' demand for excess reserves.

Benjamin Cole said...

Scott: well, we disagree. Also check out the Primary Dealers Credit Facility.

Benjamin Cole said...


Also, I think I would like to see banks increase their lending. If QE, by increasing banks' excess reserves encourages more lending, bring it on, I say. (Personally, I do not think QE encourages lending. Many people say banks always extended all the loans they could profitably, and dug up the reserves later).

In any event, I do not think banks would extend unsound loans; they have charters, fiduciary responsibilities, board of directors, and loan officers and shareholders. The best guarantee: They have the profit motive!

I have always disliked arguments that suggest if interest rates go too low, the (flimsy) free-enterprise capitalist system collapses, as banks lose their marbles in an orgy of unsound lending.

This is akin to saying the profit motive fails, and free enterprise and banking is an unstable platform on spindly stilts. The "too many reserves will compel bad lending" argument I find similarly unpersuasive (and recent history proves my point. Banks are recording fewer bad loans today than before QE started). When you think about it, The "reserves will lead to financial instability" actually sounds like an argument dreamed up by a frizzy-headed left-winger in some Ivory Tower somewhere. "You can't trust bankers with too much money. They have to be kept on a tight leash!"

Really, is this how we feel about bankers who extend capital to business or homebuyers? They turn into a bunch of lulu-Zulus when rates are too low or reserves too high?

Bankers have had all the reserves they could possibly want for many years now. From the 10qs I am reading, they are improving loan quality.

So, to summarize, if QE leads to inert results, then fine. Have the Fed buy a couple trillion more in Treasuries, and keep funneling the interest payments to the U.S. Treasury, cutting taxes. Who does not like that?

If QE leads to more lending (despite evidence to the contrary so far), then I say "Great, we want more lending." We want more economic activity. As for inflation, due to extraordinary global competition, that is not much of a concern, and the last 30 years of steadily declining inflation rates seem to bear that out. It will take a lot of demand for long, long time to generate any inflation. In the United States, the supply side is global. And they like U.S. dollars.

But, in the end I think QE just stimulates the economy though the process I originally stated.

Suppose the Fed put a table out in front of their magnificent structure in Washington D.C., and bought bonds directly from the public, printing up cash to do so (yes I know the Bureau of Engraving prints money, but for sake of argument). Would you think that inert?

So the Fed, by buying bonds from the public, but through the 22 primary dealers, obviates the stimulative impact of QE?

Side notes:

The Bank of Japan has IOER at 0.10%. Still not much inflation. They are generating more economic growth, and have had a nice equity and property rally in last couple years. The yen went to 120 from 80 to the dollar. If QE does not put more mine into circulation, I do not know why the yen sank as it did, despite better growth. Economist John Taylor raved, gushed about Japan's first QE program. Milton Friedman liked QE also.

Anyways, this comment is too long, and I enjoy Calafia Beach, and read every post closely. Can there be higher praise? It is good to remember policies in common, such as the desire to cut taxes and regulations on productive people!

Benjamin Cole said...

Add on:

"Increasing the amount of excess reserves without raising IOER could destabilize the system, giving the banks a strong incentive to reduce their excess reserves and increase their lending. This could result in an excess of money supply, and that in turn would lead to a weaker dollar and higher inflation."--Scott Grannis.

Scott, we have heard versions of "QE will lead to hyperinflation" with every round of QE, starting with QE1, then QE2, then QE3. And now we see record low rates of inflation, and 1.3% core YOY on the PCE deflator, which the Fed uses to measure inflation. We have 0.2% inflation YOY PCE straight.

When inflation-fighter Volcker left office, inflation was 4%-5% and rising...people hailed him as a hero.

If more money gets circulating due to banks lending more...well, that is what want!

BTW, I do not think banks lose control when either they have a lot of reserves or interest rates are too low, both longtime economic boogymen.

Banks have loan officers, charters, shareholders, board of directors. The best guarantee of all: They are profit-seeking enterprises. It does not behoove a bank to make bad loans.

In Japan, the interest on excess reserves is 0.10%. They have a problem with deflation. The Bank of Japan has been conducting QE regularly. Their unemployment rate is 3%.

Again, given that US supply-side has become global since the 1970s, and the world wants dollars, I do not see how we get to demand-pull inflation.

The battle going forward is for growth, not against inflation.

BTW, John Cochrane suggests converting the entire national debt into bank reserves. He contends banks with a lot of reserves are more stable as no one fears they will collapse.

In this regard, QE increases financial stability, or so contends John Cochrane.

Thinking Hard said...

Ben Bernanke Speech 8/27/10 (

"I will focus here on three that have been part of recent staff analyses and discussion at FOMC meetings: (1) conducting additional purchases of longer-term securities, (2) modifying the Committee's communication, and (3) reducing the interest paid on excess reserves. I will also comment on a fourth strategy, proposed by several economists--namely, that the FOMC increase its inflation goals."

"A rather different type of policy option, which has been proposed by a number of economists, would have the Committee increase its medium-term inflation goals above levels consistent with price stability. I see no support for this option on the FOMC. Conceivably, such a step might make sense in a situation in which a prolonged period of deflation had greatly weakened the confidence of the public in the ability of the central bank to achieve price stability, so that drastic measures were required to shift expectations. Also, in such a situation, higher inflation for a time, by compensating for the prior period of deflation, could help return the price level to what was expected by people who signed long-term contracts, such as debt contracts, before the deflation began."

Benjamin - Looks like we need to see some deflation before the 2% inflation target is altered. Also, I fully expect cuts in IOER during the next downturn to cause an uptick in bank lending, an increase in the supply of money, and lower interest rates as banks compete for borrowers. The above commentary coupled with the current Fed toolkit leads me to the conclusion of a much higher probability of an overshoot in inflation expectations coming out of the next downturn than the market is currently forecasting. You are not alone for wanting higher inflation expectations or lower IOER.

Benjamin Cole said...

Thinking: maybe so. Right now the markets as the Fed will undershoot its inflation target perhaps by as much as 100 basis points. The Fed's current too-tight policy, which could be called sadomonetarism, is not prudent and may lead to recession and financial instability.